Behind the Curtain / How Google determines ranks and rates of its sponsored links

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On any given day, Google spits back results to nearly 90 million Internet searches. And that creates about 90 million opportunities for Google to make money.

That's because for almost every word searched, Google also spits back a number of paid advertisements -- known as "sponsored links" -- that pop up right next to, or above, the regular search results.

Click on one of those sponsored links, and Google's advertisers have to pay the firm between a penny and $100.

It's a business model that made the Mountain View Internet company $6.1 billion in revenue last year, taking it to the heights of the technology world in a very short time. But in recent weeks, with questions arising about the company's growth prospects and its stock price falling more than 20 percent from its $475 peak, Google's strategy has come under increased scrutiny.

Investors are taking a closer look at how the firm makes money, and wondering whether it relies too much on a single method of creating revenue. Worse yet, there's some concern the system can be exposed to fraud and manipulation.

Google has sought to reassure Wall Street with plans to use other avenues of advertising and to expand internationally. "We are in the strongest position that we have ever been," Chief Executive Officer Eric Schmidt told analysts at a conference Thursday.

But is that enough?

Scott Kessler, a Standard & Poor's analyst, worries about what he calls Google's ABCs of risk: the absence of other means for making money; building competition; and click fraud, a practice in which competitors or scammers click on ads repeatedly, potentially costing Google and its advertisers thousands of dollars.

"It's one of the great questions people have to ponder with Google," Kessler said about click fraud.

But before laying odds on Google's future, it helps to have a better understanding of the firm's deceptively simple business model. So, how does Google make all that money?

Ads by Google

Google's advertising business appears simple. It takes just a few minutes and $5 to start posting sponsored links.

The tricky part comes as businesses battle for the top position on the first page of Google's results. Naturally, that's the sweet spot: An ad at the top of the page receives roughly double the clicks of others, said Michael Schwarz, a researcher at UC Berkeley.

But there is no way to guarantee that crucial spot. Where an advertisement appears depends on a combination of how much a business is willing to pay, and how much the ad has to do with the search.

That means that no matter how much an advertiser is willing to pay, the ad will not get top billing if the user is looking for something completely different. That also means that one company could pay less than another and wind up in a premium location, as long as Google believes its ad is the most relevant to the user's search.

To advertise on Google, businesses bid in an auction for keywords and phrases, and pay for each time their ad shows up and a user clicks on it. The cost per click is anywhere from a penny to $100. Businesses don't know how much their competitors are bidding, but they don't pay what they actually bid; they pay 1 cent above the next-highest bidder.

Omaha Steaks, which sells premium steaks and other foods, estimates it pays an average of 65 to 75 cents per click and has a roster of about 1,600 keywords like "Omaha steaks" and "filet mignon." The list climbs to about 2,000 words in advance of holidays such as Christmas and Father's Day.

The $410 million company said its efforts have paid off. It saw its revenue skyrocket 240 percent from 2004 to 2005 thanks to its Google ads, and is devoting an increasing amount of its advertising budget on them.

"It is expensive, but as long as it's efficient, we'll spend the money," said Michael Robinson, marketing manager for Omaha Steaks.

But at least two customers, floral service FTD and online jewelry retailer Blue Nile, have said in recent weeks that advertising on Google has become increasingly competitive and expensive, perhaps too expensive, with Blue Nile exploring other marketing opportunities.

Google maintains that market forces keep prices from becoming outrageous. It doesn't set prices, letting advertisers determine how much they're willing to spend, though higher prices work in Google's favor.

Some advertisers complain it's like turning over their money and letting Google do whatever it wants to decide where an advertisement runs. What's more, new, unsophisticated advertisers could end up forking over too much money because they don't realize they could get decent placement and not pay as much, a study by Harvard, Stanford and UC Berkeley researchers said.

"If some bidders are naive, and they bid the highest amount they're willing to pay, then they may end up overpaying," said Michael Ostrovsky, an assistant professor in economics at Stanford and one of the authors of the study.

To complicate matters, advertisers can also manipulate any number of factors so their sponsored link is most likely to reach the appropriate consumer, such as limiting their advertisement by language, region and time of day.

They can also specify whether they want their ad to appear only on Google or on one of Google's partner sites, including corporate destinations like AOL, Ask.com and The Chronicle's SFGate.com, as well as scores of blogs and personal sites. Google's partner sites reach 74 percent of all U.S. Internet users, according to an analysis by comScore Networks for Google.

Sharing ads with these partners is a significant business for Google, generating $2.7 billion last year, 40 percent of its total revenue. Basically, Web sites host Google's ads and then split the revenue with Google if someone clicks on the sponsored link.

"This is pure math," said Josh Stylman, managing partner at Reprise Media, a search engine marketing firm that helps customers such as Princeton Review get the most online bang for the buck. "There are a lot of levers we can pull -- which keywords we're going to buy, what is the bid price. ... We can quantify the whole equation."

Because the auction is held each time a user searches for information, the prices fluctuate. In the days leading up to Mother's Day, for instance, prices for popular keywords such as "Mother's Day" and "flowers" are likely to increase.

On online discussion boards, advertisers regularly swap tricks of the trade. For instance, to develop a history of interest in their ads, advertisers pony up more money when they're just getting started. Once they have a track record, they can lower their bids and still have a good chance their ad will get a decent spot.

But the whole process can be tough. When Judson Brady opened his Atlanta floral service two years ago, he opted to advertise only online. He read all he could about it and tried different strategies, promoting his business on Google, Yahoo, online Yellow Pages and a San Francisco service called Ingenio, which charges him when a customer gives him a call after seeing a toll-free number posted in an online advertisement.

The online ads, particularly the pay-per-call service, which Google is also testing, have certainly sent business his way. But six months ago, he decided to quit Google, finding it wasn't worth it. "It was way too expensive to be profitable, and way too complicated," he said.

Advertisers also have another concern about using Google: fraudulent clicking.

Virtual chicanery

Click fraud occurs when someone other than a typical Internet user clicks on a sponsored link repeatedly. Competitors do it to drive their rivals out of business, forcing them to waste their budget on useless clicks.

In another twist on the scam, Web site owners that publish Google ads can make a quick buck by clicking on ads on their own Web site, because Google pays them a portion of the proceeds.

Though certainly not new, it has become more underhanded over time. Scammers now use software that automatically clicks on ads, but makes it look like random people are doing it. They also employ cheap workers overseas to click on ads manually or create networks of spam Web sites and blogs. Generally, the higher-priced the keyword, the more likely it becomes a target for cheats. Observers say most of the fraud these days happens not on Google, but on Google's partner sites.

Google monitors it all closely, shutting down bogus sites and going after the bad guys. "We stay ahead of the curve," said Shuman Ghosemajumder, a Google business product manager who focuses on invalid clicks.

"The more simplistic the technique, the greater the likelihood we've thought about it a long time ago," he said.

But some industry observers worry that click fraud could be getting worse, threatening Google's livelihood.

Because Google makes its money from online advertisers, it is more vulnerable to click fraud. Wall Street analysts say it could force Google to issue more refunds and make potential advertisers wary about getting into paid search.

"I don't think sophisticated advertisers are overly concerned, because they've been employing Google and already know what they're getting from Google," said Kessler of Standard & Poor's. "But some people experimenting with Internet advertising, maybe those folks aren't going to embrace Internet search advertising, or not with the magnitude if there weren't the specter of click fraud out there."

Advertisers are beginning to wake up to click fraud, said Scott Boyenger, co-founder of Click Defense, which develops software for businesses to use if they've been hit by it. "Before, people didn't know what the term was," he said.

In a study, MarketingExperiments.com found that up to 30 percent of clicks on Google and its partner sites could be fake. "By the time it's happening, you've already paid for it," said Jalali Hartman, director of strategy for MarketingExperiments.com.

There's enough concern that an entire ecosystem has sprung up to combat click fraud. "We feel it's a huge business," said Michael Caruso, co-founder of ClickFacts, with offices in San Francisco and Boston, which also develops software to keep tabs on click fraud.

In one instance, Google credited $13,000 to E-magine Networks Inc. for click fraud after the Fort Lauderdale, Fla., company, which runs a series of Web sites and helps businesses promote themselves online, presented Google with evidence unearthed by ClickFacts' software.

"They took it and reviewed it for two to three months, and got back to us," said Joseph Dupell, co-founder of E-magine Networks. "They decided to give us credit. We didn't have to wait for it. As soon as they tell you, you get (the credits) the same day. That's good about what Google does. You can't fault Google."

In most cases, Google wipes out fraudulent clicks before its customers even have a chance to see them. The firm uses software, which its engineers continually update, to search for irregular clicking patterns and filter out what it believes are invalid clicks. It also deploys a team of employees to analyze and investigate account data for possible fraud.

"It's like the radar detection industry. You have two constituents trying to outsmart each other," said Stylman of Reprise Media. "This is perhaps the only visible risk to a booming industry. There is a lot at stake for (Google)."

The depth of the problem isn't clear, because Google will not disclose details about click fraud. Google's Schmidt said Thursday that the impact of click fraud is "not material" and declined to get more specific. Google also said that studies on click fraud are wildly exaggerated and the number of fraudulent clicks it removes beforehand is far more than the number of requests it's received for refunds, which is "very small."

Some observers argue it's not as bad as critics say. Theoretically, repeated clicks on a company's ad could actually be beneficial, because its track record improves and should eventually mean that the company pays less, said Schwarz of UC Berkeley.

Do the ads work?

Advertisers are also becoming savvier in tracking whom Google sends to its Web sites, and whether those users are going on to make purchases, said John Rodkin, founder and CEO of Click Shift of San Bruno, which develops software to monitor just that. With it, advertisers can monitor their ads 24 hours a day, yanking out keywords that don't produce results.

If you're good at figuring out how to get the right users to arrive at your site, "then how the clicks are generated becomes less important to you," he said. "I think that advertisers as a whole are becoming more sophisticated, and when they're more sophisticated, they face less danger."

So far, click fraud doesn't appear to be slowing down search advertising. That segment raked in an estimated $5.4 billion, 42 percent of all online advertising dollars in the United States last year, according to eMarketer, and is projected to climb to $9.6 billion in 2009.

In January, U.S. consumers used Google for 2.8 billion searches, or nearly 50 percent all of online queries, according to Nielsen/NetRatings. That helped produce 41.1 billion sponsored links in January on Google and its partner sites. And the experience with click fraud hasn't stopped E-magine Networks and other businesses from continuing to use Google.

"I'm not trying to be angry with Google. I want to work with Google," said Dupell of E-magine Networks.

"It is not an evil corporation," he continued. "It may be a place where fraud does occur, but Google does refund the money back if it can be proven. ... They have made us a fortune and they've made our clients a fortune and they continue to every day."

How to do it

Placing an advertisement on Google can cost as little as $5 and take just a few minutes.

1. Draw up a three-line advertisement, no more than 100 characters total.

2. Enter the keywords that will activate your sponsored link, such as "cheap airfare" for an ad about discount travel.

3. Bid in an auction for those keywords, determining how much you're willing to pay. The minimum bid is 1 cent per click. The maximum is $100 per click. You can't spend more than $250,000 a day.

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